Europe is toxic but money can still be made

By Jason Kerr

Whenever I talk to people about their investments, the inevitable question comes up. Should I invest in Europe, it’s so cheap. Umm, well…Yes and no. If you invest in Europe, you might as well just invest in Germany. Whether the euro zone continues to exist in its current form, or becomes something new, Germany is still going to be the king of Europe. The euro zone had a €4.3 billion trade surplus in the 2nd quarter of 2011. Germany contributed €11.8 billion to that surplus. Removing Germany, the euro zone would have experienced a €7.5 billion trade deficit. That is they would import more than they export.

If you continue to look at the past trade balance of the euro zone, you will see that Germany is the primary driver of trade surpluses. Most other countries, including the southern ones like Portugal, Spain, France, Italy and Greece have persistent trade deficits. Consistent trade deficits of these aforementioned countries create an imbalance within the euro zone. The fact is these countries are importing more than they are exporting, and have been paying for this via increased asset valuations that allowed these nations to take on increasing levels of debt. In effect, GDP increased faster than under ‘normal’ conditions, allowing for increased levels of debt backed by increased asset values.

It is not a coincidence that one of the euro countries most in trouble, Ireland, is further down the economic healing path than other euro countries. Ireland has a consistent trade surplus. The balance of trade metric has been a good indication of how well a country would do under economic stress. The problem is, those countries next in line for euro help, Italy and Spain, both have persistent trade deficits.

The fact is austerity is not the best medicine for a country with persistent trade deficits. The root of the problem is not from spending, but from an economy growing at an unnatural rate. That unnatural economic growth boosted spending, which helped perpetuate the growth, which perpetuated the spending and so on and so forth. By focusing on austerity, lenders have said that debt will not be paid via economic growth, but from a rapid economic contraction. The same conditions that existed in Greece and Portugal also appear to exist in Spain, Italy and France. Only Spain and Italy are closer to the edge than France, as French debt to GDP it is not nearly at Spanish or Italian levels. Thus Spain and Italy are most likely to follow the Greeks and the Portuguese down economic contradiction via austerity. By delaying the imposition of massive austerity on Spain and Italy, France and Germany are hoping that economic growth will help ease the burden. In effect, it appears they have come to the realization that they can’t bail out Spain and Italy.

Bankruptcy would be inevitable for Spain and Italy without French and German help. Rapid recapitalization of French and German banks would need to be undertaken. But Germany will not be keen to get off the euro. This entire sovereign debt crisis has resulted in a depreciated euro, boosting German exports. If Germany can delay the crisis from a breaking point, it may build itself enough of a cushion to be able to bail out its banks and keep the German industrial complex humming. France on the other hand is running a trade deficit at a depreciated exchange rate. It’s living on a hope and a prayer that Spain and Italy don’t go off the edge.

Since downside risk exists even with Germany, a long/short strategy focusing on German outperformance is probably the best play. Going long iShares Germany (EWG) and shorting iShares France (EWQ) will be profitable if German equities outperform French. Comparing the two, EWQ has outperformed EWG over the last 3 months, but year-to=date they have identical returns. Over the next 12 months, German fundamentals should prevail and EWG should outperform EWQ.

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